UNITED STATES TAX COURT

102 T.C. No. 33

.r.

UNITED STATES TAX COURT

. EXXON CORPORATION AND AFFILIATED COMPANIES, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 18618-89, 18432-90.

Filed June 6, 1994.

Held: In computing allowance for percentage

depletion, it is unreasonable to determine petitioners'

1979 "gross income from the property" for sales of

natural gas after it was transported away from the

wellhead by the method provided for in the last

sentence of sec. 1.613-3(a), Income Tax Regs., the

representative market.or field prices, where those

prices result in a "gross income from the property"

that is approximately five times petitioners' actual

contract sales revenue in connection with such sales;

accordingly, in this case it is reasonable to use a

net-back method. Respondent's motion for partial

summary judgment will be granted, and petitioners'

cross-motion for partial summary judgment will be

denied.

Robert L. Moore II, for petitioners.

Val J. Albright, Stephen C. Coen, and James E. Archie, for

respondent.

SERVED JUN 8 1994

- 2 WHITAKER, Judge:

This issue is before the Court on the

parties' timely motion and cross-motion for partial summary

judgment pursuant to Rule 121l.

In support of Respondent's

Motion for Partial Summary Judgment respondent contends that

petitioners are not entitled to a percentage depletion deduction

based upon a hypothetical "gross income from the property" that

exceeds petitioners' actual gross income from the sales of the

gas at ~issue.2

Petitioners in support of Petitioners' Cross-

Motion for Partial Summary Judgment contend that, under the

literal terms of section 1.613-3(a), Income Tax Regs., they must

compute their percentage depletion deduction by using the

"representative market or field prices" (RMFP's) of the gas at

issue.3

Unless otherwise noted, all section references are to the

Internal Revenue Code of 1954, as amended and in effect for the

years in issue, and all Rule references are to the Tax Court

Rules of Practice and Procedure.

2 Respondent's motion was filed in both docket Nos. 18618-89

and 18432-90. However, the substance of the motion pertains only

to docket No. 18618-89 and the tax year 1979. The same is true

with regard to petitioners' cross-motion. Respondent indicated

in the Memorandum of Law in Support of Respondent's Motion for

Partial Summary Judgment that "the legal principle at issue with

respect to the motion is directly applicable to a number of other

percentage depletion issues in that case and the case at Docket

No. 18432-90." Because we have no knowledge about the facts

pertaining to years other than 1979, we express no opinion as to

the applicability of the principles discussed in this opinion to

other years. We do note, however, that respondent expressly

stated that the motions at issue only relate "to depletion

claimed for alleged fixed contracts", which also may limit the

scope of the applicability of this opinion to other years.

3 See supra note 2.

- 3 FINDINGS OF FACT

During the taxable year 1979, Exxon Company, U.S.A. (Exxon

USA), a division of petitioner Exxon Corporation (Exxon),

produced natural gas in Texas, and transported the gas through

the Exxon Industrial Gas System (EGSI).4

On their return for the

taxable year 1979, petitioners claimed a depletion deduction

relative to natural gas transported by EGSI.

In calculating this

percentage depletion, petitioners used a figure for the "gross

income from the property", a percentage of which constitutes the

depletion allowance, in the amount of more than $495,000,000.

This amount was based upon purportedly appropriate RMFP's for the

subject natural gas, after transportation, manufacture, or

conversion.

Petitioners applied a 22 percent depletion rate to

petitioners' "gross income from the property", for a deduction in

the amount of $109,017,036.

Because of their fixed price

contracts, petitioners' actual 1979 contract sales revenue of gas

produced by Exxon USA and transported by EGSI for delivery under

fixed contracts to certain industrial customers was considerably

less than they could have sold it in the absence of such

contracts.

That actual revenue was approximately $95,502,000, or

about one-fifth of the "gross income from the property" for

depletion purposes claimed by petitioners on their 1979 return

4 Respondent's brief states that the gas at issue was

transported through a pipeline system owned by Exxon Gas Systems,

Inc. (EGSI). We use the EGSI initials in this opinion to refer

to the system, which is consistent with the parties' usage.

- 4 -

for this gas.

The difference between petitioners' claimed "gross

income from the property" for purposes of depletion and

petitioners' actual gross receipts from the sales of the natural

gas at issue was not included in Exxon's 1979 gross income or

taxable income for purposes of section 61 or 63.

Respondent conceded solely for purposes of respondent's

motion several facts which involve other issues related to

percentage depletion that respondent apparently believes might

have required us to deny respondent's motion because of the

existence of an issue of material fact.

Solely for purposes of

respondent's motion,s we find as follows:

(1) Exxon possessed the requisite economic

interest in the wells for which percentage depletion is

claimed;

(2) the gas at issue was sold under fixed price

contracts within the meaning of sections 613A(b)(1)(B)

and 613A(b)(3)(A);

(3) the volumes of gas claimed by petitioners to

be qualified for percentage depletion are so qualified;

(4) petitioners properly computed the royalty

exclusion;

5 We view the parties' motions here essentially as two sides

of the same coin. However, concessions that one party makes in

support of his motion do not carry over and support the crossmotion of his adversary. 6 Moore, Moore's Federal Practice, par.

56.13, at 56-176 (2d ed. 1993). Accordingly, respondent's

concessions apply only to respondent's motion. In opposition to

petitioners' cross-motion respondent has submitted affidavits

attempting to show that there are numerous issues of material

fact in this case, which pertain to the same issues as those

contained in respondent's concessions made in connection with

respondent's motion. Some of these issues would become moot if

we ruled in favor of respondent's motion. These issues would

have to be resolved if we ruled in favor of petitioners' crossmotion.

- 5 -

(5) the gas at issue was not "sold on the premises

but [was] manufactured or converted into a refined

product prior to sale, or [was] transported from the

premises prior to sale" within the meaning of section

1.613-3(a), Income Tax Regs.;

(6) there are one or more RMFP's for the gas at

1ssue;

..

(7) the RMFP's determined by petitioners are

"market or field prices" as defined by section 1.6133(a), Income Tax Regs., and are "representative" within

the meaning of that regulation for the gas at issue,

but for the fact that they exceed the amounts for which

the gas was actually sold;

(8) an RMFP may exceed the maximum lawful selling

price of the gas, and/or the maximum lawful selling

prices for the gas at issue were equal to or exceeded

the alleged RMFP's used by petitioners;

(9) cost depletion with respect to the gas at

issue does not exceed percentage depletion;

(10) the taxable income limitation provided by

section 613(a) does not otherwise limit petitioners'

percentage depletion deduction;

(11) the actual sales proceeds for the gas at

issue do not require further reduction for any income

attributable to post-production activities; and

(12) section 1.613-3(c)(6), Income Tax Regs., does

not otherwise limit petitioners' percentage depletion

deduction.

In respondent's determination of "gross income from the

property", respondent used a type of net-back methodology,

whereby the actual revenues received by petitioners for the gas

after transportation were reduced by royalties in connection with

- 6 -

the wells at issue, which resulted in a complete disallowance.'

Petitioners ask us to hold that Exxon must use the applicable

RMFP's as the figure for "gross income from the property" for

purposes of percentage depletion where the gas is transported

away from the well.

Respondent asks the Court to hold that

petitioners' "gross income from the property" for purposes of

percentage depletion cannot exceed the actual gross income from

the sale of the gas minus the royalty exclusion required by

section 613(a); thus respondent effectively contends that under

these circumstances respondent may employ a net-back methodology

to determine "gross income from the property".

OPINION

Rule 121(b) provides that this Court may grant a summary

adjudication in favor of the moving party where it has been shown

that "there is no genuine issue as to any material fact and that

a decision may be rendered as a matter of law."

Respondent has

conceded, solely for purposes of respondent's motion, the

propriety of petitioners' depletion deduction other than with

respect to the legal issue at hand.

appropriate to do so.

340, 345 (1982).

We have held that.it is

E.g., Jacklin v. Commissioner, 79 T.C.

While there are several factual disputes

concerning other aspects of petitioners' depletion deduction, the

6 While typically a net-back methodology also would have

required the reduction of the gross income by transportation

expenses, in this case the royalty exclusion resulted in a

complete disallowance, and further reduction was unnecessary.

parties appear to agree that there is no issue as to any material

fact with respect to the specific legal question before us.

Consequently, it is ripe for summary judgment.

6 Moore, Moore's

Federal Practice, par. 56.13, at 56-177 (2d ed. 1993).

Section 611 allows a "reasonable allowance for depletion" in

the case of, inter alia, oil and gas wells, "according to.the

peculiar conditions in each case".

Section 613(a) provides for a

percentage depletion deduction based upon a percentage of a

taxpayer's "gross income from the property".7

While the statute

is silent as to the definition of "gross income from the

property" as it relates to the issue before us, respondent's

regulations provide that it means

the amount for which the taxpayer sells the oil or gas

in the immediate vicinity of the well. If the oil or

gas is not sold on the premises but is manufactured or

converted into a refined product prior to sale, or is

transported from the premises prior to sale, the gross

income from the property shall be assumed to be

equivalent to the representative market or field price

of the oil or gas before conversion or transportation.

Sec. 1.613-3(a), Income Tax Regs.

Petitioners assert that, under

the literal terms of this regulation, where, as here, the gas was

transported from the premises prior to sale, respondent may not

use a net-back methodology to determine gross income from the

property, but must apply the literal language of section 1.6133(a), Income Tax Regs., and use the RMFP's, the result of which

7 As discussed infra, percentage depletion was repealed for

tax years after 1974, but certain taxpayers who sold gas under

"fixed contracts" continued to qualify for this more favorable

method.

- 8 -

is considerably higher than the amount actually received by

petitioners after the gas was transported away from the well.

The parties have not cited, and the Court has not found, any

published opinion of this Court directly involving this issue.8

Petitioners contend that we must follow the literal language

of the regulation at issue and require use of the RMFP's without

further analysis.

Petitioners essentially rely upon the so-

called "ordinary meaning" or "plain meaning" rule, whereby courts

have held that, in the exercise of judicial restraint, the plain

words of a regulation should be followed where those words are

clear and unambiguous, without resort to legislative intent or

legislative history.

Petitioners refer to this Court's holding

that, "When the authority to prescribe legislative regulations

exists, this Court is not inclined to interfere if the

regulations as written support the taxpayer's position."

Walt

Disney, Inc. v. Commissioner, 97 T.C. 221, 228 (1991), revd. on

other grounds 4 F.3d 735 (9th Cir. 1993); see also Transco

8

We note that the Court of Federal Claims, in an order in

another case involving the same issue in Exxon's 1974 tax year,

addressed this issue and held that the literal language of the

regulation controlled. Docket No. 660-89T (6/29/93). For the

reasons discussed below, we do not agree with the conclusion of

this order on this issue. See Panhandle Eastern Pipe Line Co. v.

United States, 187 Ct. Cl. 129, 408 F.2d 690, 716, 717 (1969).

Also, Rev. Rul. 90-62, 1990-2 C.B. 158, addressed the issue and

concluded that, if gas is sold after it is transported from the

wellhead for a price that is lower than the RMFP, gross income

from the property is determined for purposes of percentage

depletion without regard to the RMFP. However, as we have often

stated, a revenue ruling is only a statement of respondent's

position and is entitled to no precedential weight.

Exploration Co. v. Commissioner, 95 T.C. 373, 383-384 (1990),

affd. 949 F.2d 837 (5th Cir. 1992); Woods Investment Co. v.

Commissioner, 85 T.C. 274, 281-282 (1985).

Respondent cites the

plain meaning of the words "gross income" in section 613(a) to

assert that the correct interpretation of the regulation at issue

is that "gross income from the property" can never exceed "gross

income".

Respondent contends that petitioners' interpretation of

the last sentence of section 1.613-3(a), Income Tax Regs., is to

amend the phrase "gross income from the property" to read "gross

value of the property", which would be inconsistent with the

legislative history of percentage depletion generally and of this

sentence of the regulation specifically.

The regulation at issue is legislative in nature,' and the

rules of interpretation applicable to statutes should be used in

determining the meaning of legislative regulations.

1A Singer,

Sutherland Statutory Construction, sec. 31.06 at 532 (4th ed.

1985); see Trustees of Indiana University v. United States, 223

Ct. C1. 88, 618 F.2d 736, 739 (1980); Rucker v. Wabash Railroad

Com, 418 F.2d 146, 149 (7th Cir. 1969).

The cases discuss two

principles which, although often used to achieve opposite

9 Sec. 611(a) provides: "[S]uch reasonable [depletion]

allowance in all cases [is] to be made under regulations

prescribed by Secretary." Where a regulation is promulgated

pursuant to a specific statutory authority, it is a substantive

rule, legislative in character. Wing v. Commissioner, 81 T.C.

17, 28 (1983) (depletion regulations are legislative in character

and thus subject to the Administrative Procedure Act, 5 U.S.C.

secs. 500-559 (1988)).

- 10 results, are essentially consistent with one another.

The first

is the well-established principle that, where the language at

issue is ambiguous, it is necessary to examine the underlying

statutory framework and legislative history to understand its

correct meaning.

Emery Mining Corp. v. Secretary of Labor,

744 F.2d 1411, 1414 (10th Cir 1984) (construe ambiguous statute

in light of statute it implements).

On the other hand it also

has been stated that

courts are forbidden to tamper with the plain meaning

of the words employed unless they are clearly ambiguous

or nonsensical. The concomitant rule of interpretation

is that courts may not re-write inartfully but

unambiguously drafted legislation in order to

accomplish results perceived by the court to be the

goals of such flawed legislation.

Grider v. Cavazos, 911 F.2d 1158, 1162 (5th Cir. 1990).

Accord

King Ranch, Inc. v. United States, 946 F.2d 35, 37 (5th Cir.

1991); International Trading Co. v. Commissioner, 484 F.2d 707,

711

(7th Cir. 1973), revg. and remanding 57 T.C. 455 (1971).

We

are not prepared to reach the conclusion that the regulation at

issue is so clear on its face that we cannot call it ambiguous.

Indeed, there is considerable room for argument that the

regulation is quite ambiguous."

But even if we were to conclude

We note that petitioners concede the ambiguity of the

language at issue at one point in their brief. It is arguable

that the pertinent language, that "the gross income from the

property shall be assumed to be equivalent to the representative

market or field price of the oil or gas before conversion or

transportation", contains sufficient ambiguity that there is room

for interpretation of the underlying purpose of the statute.

(Emphasis added.) The word "assume" commonly means to "take as

granted or true" (Webster's Ninth New Collegiate Dictionary

(continued...)

- 11 -

that the regulation is not "clearly ambiguous" on its face, the

rule of statutory construction quoted above also requires us to

determine whether the "plain meaning" would have a nonsensical

result in the context of the facts in this case.

In making this determination, our review of the cases has

revealed that there has been considerable erosion of the rule

foreclosing inquiry of legislative purpose even in the context of

"clear" language.

A long line of precedent establishes the

principle. that a provision may be interpreted in a manner

contrary to its unambiguous language "when the intent of the

legislative scheme clearly indicates a result contrary to that

dictated by" the literal language.

Abdalla v. Commissioner,

647 F.2d 487, 496 (5th Cir. 1981), affg. 69 T.C. 697 (1978).

"It

is a familiar rule, that a thing may be within the letter of the

statute and yet not within the statute, because not within its

spirit nor within the intention of its makers."

United

(...continued)

(1985)) or to "pretend" (Black's Law Dictionary 122 (6th ed.

1990)). However, the implication in this word as well as in its

close counterpart "presume" ("to assume beforehand" (Black's Law

Dictionary 1185 (6th ed. 1990)) is that there is room for

potential dispute if the "assumption" does not hold with logic or

substance; hence there is the "rebuttable presumption". Contrary

to petitioners' assertion that the language of this regulation

mandates a "conclusive presumption", we find no such conclusive

presumption to exist and, even if we were not otherwise permitted

to do so as we discuss in the text, we believe that there would

be sufficient ambiguity in this language to permit examination of

legislative intent under the "plain meaning rule". Cf. Fed. R.

Evid. 301. We note also that understanding "representative

market or field price" requires some interpretation as to the

meaning of these terms in this situation. Sec. 1.613-3(a),

Income Tax Regs. (Emphasis added.)

- 12 Steelworkers of America v. Weber, 443 U.S. 193, 201 (1979)

(quoting Church of the Holy Trinity v. United States, 143 U.S.

457, 459 (1892)).

Accordingly, the plain meaning rule does not

preclude an examination behind the literal terms of the language

at issue if the lack of such an examination would "compel an odd

result".

Public Citizen v. United States, 491 U.S. 440, 454

(1989) (quoting Green v. Bock Laundry Machine Co. 490 U.S. 504,

509 (1989)).

The Supreme Court summarized this as follows:

As we said in Church of the Holy Trinity v. United

States, 143 U.S. 457, 459 (1892):

"[F]requently words

of general meaning are used in a statute, words broad

enough to include an act in question, and yet a

consideration of the whole legislation, or of the

circumstances surrounding its enactment, or of the

absurd results which follow from giving such broad

meaning to the words, makes it unreasonable to believe

that the legislator intended to include the particular

act."

Where the literal reading of a statutory term

would "compel an odd result," Green v. Bock Laundry

Machine Co., 490 U.S. 504, 509 (1989), we must search

for other evidence of congressional intent to lend the

term its proper scope. See also, e.g., Church of the

Holy Trinity, supra, at 472; FDIC v. Philadelphia Gear

Corp., 476 U.S. 426, 432 (1986).

"The circumstances of

the enactment of particular legislation," for example,

"may persuade a court that Congress did not intend

words of common meaning to have their literal effect."

Watt v. Alaska, 451 U.S. 259, 266 (1981). Even though,

. as Judge Learned Hand said, "the words used, even in

their literal sense, are the primary, and ordinarily

the most reliable, source of interpreting the meaning

of any writing," nevertheless "it is one of the surest

indexes of a mature and developed jurisprudence not to

make a fortress out of the dictionary, but to remember

that statutes always have some purpose or object to

accomplish, whose sympathetic and imaginative discovery

is the surest guide to their meaning." Cabell v.

Markham, 148 F.2d 737, 739 (CA2), aff'd, 326 U.S. 404

(1945). Looking beyond the naked text for guidance is

perfectly proper when the result it apparently decrees

is difficult to fathom or where it seems inconsistent

_ 13 with Congress' intention, since the plain-meaning rule

is "rather an axiom of experience than a rule of law,

and does not preclude consideration of persuasive

evidence if it exists." * * * . Boston Sand & Gravel

Co. v. United States, 278 U.S. 41, 48 (1928) (Holmes,

J.).

Public Citizen v. United States, supra at 453-455; see also

Commissioner v. Brown, 380 U.S. 563, 571 (1965); United States v.

American Trucking Associations, 310 U.S. 534, 543-544 (1940).

Although there has at times been disagreement as to their

applicability to particular statutes and legislative scenarios,

these principles have been applied in cases before this Court.

E.g., Estate of Sachs v. Commissioner, 88 T.C. 769, 773 (1987),

affd. in part and revd. in part on other grounds 856 F.2d 1158

(8th Cir. 1988); Knowlton v. Commissioner, 84 T.C. 160, 162-165

(1985), affd. 791 F.2d 1506 (11th Cir. 1986); Carson v.

Commissioner, 71 T.C. 252, 262 (1978), affd. 641 F.2d 864 (10th

Cir. 1981); Carasso v. Commissioner, 34 T.C. 1139, 1142 (1960),

affd. 292 F.2d 367 (2d Cir. 1961); see also DePaolis v.

Commissioner, 69 T.C. 283, 285-288 (1977).

Where, however, a

provision is clear on its face, we should require unequivocal

evidence of legislative purpose before construing a statute so as

to override its plain meaning.

Huntsberry v. Commissioner,

83 T.C. 742, 747-748 (1984); Busse v. Commissioner, 58 T.C. 389,

392 (1972), affd. 479 F.2d 1147 (7th Cir. 1973).

Accordingly, we

briefly examine the legislative purpose and history of percentage

depletion to ascertain whether and to what extent the statutory

- 14 -

framework comports with a literal interpretation of the

regulation at issue.

Originally depletion was intended to constitute a tax-free

return of the taxpayer's investment or as a recoupment to the

taxpayer for exhaustion of the resource.

Commissioner v.

Portland Cement Co., 450 U.S. 156, 167 (1981); United States v.

Cannelton Sewer Pipe Co., 364 U.S. 76, 81 (1960); Commissioner v.

Southwest Exploration Co., 350 U.S. 308, 312 (1956); Brea Canon

Oil Co. v. Commissioner, 29 B.T.A. 1134, 1137 (1934), affd. 77

F.2d 67 (9th Cir. 1935).

In the Revenue Act of 1913, the first

cost method of computing depletion deductions was established.

Revenue Act of 1913, ch. 16, secs. II(B), II(G)(b), 38 Stat. 167,

172.

Under this approach, a producer could deduct the total cost

of the property or its March 1, 1913, fair market value,·

whichever was higher, over the life of the property, not to

exceed 5 percent of the gross value of production during the

year."

See Staff of Joint Comm. on Taxation, Legislative

History of Depletion Allowances 1 (1950) (Staff Summary); Burke,

Incentives to Develop Natural Resources:

Factors Affecting

Industries Involved in Natural Resource Exploitation; Oil and

Gas; Hard Minerals; Timber, 33 N.Y.U. Inst. on Federal Taxation

1541, 1542-1543 (1975) (Burke).

In order to encourage investment

In the Revenue Act of 1916, the 5 percent.limitation was

abandoned and the depletion amount was not to exceed the invested

capital (cost) or the March 1, 1913, value. Revenue Act of 1916,

ch. 463, secs. 5(a)(8), 12(a)(2), 39 Stat. 759, 768.

- 15 -

and development of badly needed oil supplies, the 1918 Revenue

Act contained a new method called "discovery depletion", whereby

the value of the depletable property was permitted to be based

upon the cost or fair market value of the property at the date of

discovery of oil or within 30 days thereafter.

Revenue Act of

1918, ch. 18, secs. 214(a)(10), 234(a)(9), 40 Stat. 1067-1068,

1078.

Subsequently, there was concern, however, that

corporations frequently were taking advantage of this valuation

method and using it to obtain depletion deductions in excess of

income, thereby offsetting income from corporate activities

unrelated to the depleted property.

See Hearings on H. R. 8245

Before the Senate Comm. on Finance, 67th Cong., 1st Sess. 266

(1921); S. Rept. 275, 67th Cong., 1st Sess. 15 (1921), 1939-1

C.B. (Part 2) 181, 191.

Thus in 1921 a limitation was added to

discovery depletion that it could not exceed the net income from

the property.

Stat. 256.

Sec. 234(a)(9), Revenue Act of 1921, ch. 136, 42

Regulations implementing the net income limitation of

this provision defined "net income" as "the gross income from the

sale of all mineral products * * * less operating expenses"; they

also provided that, in the event that products were manufactured

or refined prior to sale, ."the gross income shall be assumed to

be equivalent to the market or field price of the raw material

before conversion", a concept employed in the regulation at

issue.

Regs. 62, art. 201(h) (1922).

As a result of

congressional concern about continued instances in which

- 16 -

corporations overvalued depletable properties," this limitation

was reduced further to 50 percent of net income by the Revenue

Act of 1924, ch. 234, sec. 204(c), 43 Stat. 260."

Valuations of properties, however, caused frequent disputes

between taxpayers and taxing authorities, and these

administrative and valuation difficulties resulted in the

development of a completely new type of depletion.

at 1544-1545.

Burke, supra

Not surprisingly, experience had shown that the

value of oil in the ground for discovery depletion purposes was

consistently related to the market price of the oil.

Percentage Depletion:

Austin,

Its Background and Legislative History,

21 Kan. City U. L. Rev. 22, 26-27 (1952).

An approximately

equivalent overall result to discovery depletion was able to be

12

The Joint Committee Staff reported that Ways and Means

Committee Chairman Green had expressed the following concern:

At present [a depletion deduction] may be as great as

the entire net income on the property depleted, and I

have known instances where companies actually

advertised that they could make a distribution of their

dividends without paying any corporation tax * * *. I

think in many instances they have succeeded in evading

the corporation tax through depletion allowances.

Staff of Joint Comm. on Taxation, Legislative History of the

Depletion Allowances 5 (1950).

13

A Treasury Ruling in 1926 also was directed toward these

concerns about depletion deductions being used to offset other

income. It ruled that, under discovery depletion, an amount in

excess of the fair market value of the product from the property

at the date of discovery could not be applied against income from

other sources. I.T. 2269, V-1 C.B. 256 (1926). This ruling was

interpreting depletion under the Revenue Act of 1918 which, as

discussed in the text, was based upon the fair market value at

the date of discovery.

- 17 -

achieved through a new concept whereby depletion was allowed as a

percentage of income.

Accordingly, in the Revenue Act of 1926,

"In the interest of simplicity and certainty in administration",

H. Rept. 356, 69th Cong., 1st Sess. 31 (1926), 1939-1 C.B.

(Part

2) 362, discovery depletion was eliminated and a system of

percentage depletion was enacted, whereby 27.5 percent of the

gross income from the property became the measure for the

depletion allowance.

Sec. 204(c)(2), ch. 27, 44 Stat. 16.

The

50 percent of net income limitation was retained in the new

provision.

In discussing the general effect of the 1926 Act, the Joint

Committee Report described the relevant terms as follows:

"From the property" is interpreted to mean from

each individual tract or lease. In other words, the

net or gross income must be computed not for all the

properties of the taxpayer lumped together, but from

each individual leasehold.

"Gross income from the property" may be defined,

therefore, for oil and gas properties, as the gross

receipts from the sale of oil and gas as it is

delivered from the property less the royalties paid in

cash, if any. As it is not customary for operators to

report oil royalties as a part of their receipts

ordinarily, gross income will coincide with gross

receipts. * * * . In the case of taxpayers who are

operators, refiners, transporters, etc., the gross

income from the property must be computed from the

production and posted price of oil, as the gross

receipts from a refined and transported product can not

be used in determining the income as relating to an

individual tract or lease.

[Emphasis added.]

Staff of Joint Comm. On Internal Revenue Taxation, Preliminary

Report on Effect of Section 204(c)(2), Revenue Act of 1926,

- 18 Depletion of Oil and Gas Wells 12-13 (1927)."

As it indicates,

the last sentence in the above quote was designed to provide

guidance as to how to separate from the refining and

transportation aspects of the resulting product that portion of

the gross receipts which were attributable to the product as it

came out of the ground before transportation or refinement.

A

few years later in 1929, respondent incorporated the method

employed by this concept into a regulation dealing with the

definition of "gross income from the property", the predecessor

to the regulation at issue (see Regs. 74, art. 221(i) (1931)),

and, with a few minor amendments in 1933 and 1936, the amended

regulations under the 1939 Code provided:

In the case of oil and gas wells, "gross income from

the property" as used in section 114(b)(3) means the

amount for which the taxpayer sells the oil and gas in

the immediate vicinity of the well. If the oil and gas

are not sold on the property but are manufactured or

converted into a refined product prior to sale, or are

transported from the property prior to sale, the gross

income from the property shall be assumed to be

equivalent to the representative market or field price

(as of the date of sale) of the oil and gas before

conversion or transportation.

Sec. 39.23(m)-1(e)(1), Regs. 118 (1953).

According to the

testimony of Mr. B.H. Bartholow, then a Special Assistant to the

Secretary of the Treasury, at hearings before the Joint Committee

in 1930, the purpose for the use of the market or field price of

While Joint Committee on Taxation staff explanations are

not technically legislative history, we find this one to be

useful in understanding the background meaning of the terms at

issue, as did the Supreme Court in United States v. Cannelton

Sewer Pipe Co., 364 U.S. 76, 81 (1960).

- 19 -

oil at the well was to eliminate post-extraction income from the

depletion computation.

See Hearings Before the Joint Committee

on Internal Revenue Taxation, 71st Cong., 3d Sess. at 104, 111

(1930).

The RMFP approach also was found to be designed to

prevent discrimination in favor of integrated producers by

eliminating profits attributable to post-production processes.

See Hugoton Prod. Co. v. United States, 172 Ct. Cl. 444, 349 F.2d

418, 425-427 (1965) (citing United States v. Cannelton Sewer Pipe

Co., 364 U.S. 76 (1960)).

This provision remained substantially

the same under the 1954 Code, except that the phrase "(as of the

date of sale)" has been deleted.

See sec. 1.613-3(a), Income Tax

Regs.

In 1932, percentage depletion was extended to metal, coal,

and sulphur mines.

47 Stat. 203.

Revenue Act of 1932, ch. 209, sec. 114(b)(4),

Over the next several years, percentage depletion

was applied to various other metals and nonmetals.

at 20-31.

Staff Summary

In 1969, the percentage depletion rates were changed,

including reduction in the rate on oil and gas production from

27.5 percent to 22 percent, Tax Reform Act of 1969, Pub. L. 91-

172, sec. 501(a), 83 Stat. 629.

But the basic substance of

percentage depletion as it applied to oil and gas did not change

until 1974, when percentage depletion was repealed for·tax years

after 1974, with certain exceptions.

Tax Reduction Act of 1975,

Pub. L. 94-12, sec. 501, 89 Stat. 47.

Most taxpayers who took a

depletion deduction after February 1, 1975, were not permitted to

- 20 -

use percentage depletion under section 613.

Sec. 613A(a).

It is

under the fixed contract exception contained in section

613A(b)(1)(B)

that petitioners claim that they continue to

enjoy the benefit of a 22-percent depletion rate.

The conference

report on the Tax Reduction Act of 1975 indicates that percentage

depletion was continued for natural gas sold under fixed price

contracts because those contracts did "not permit price

adjustment after * * * [February 1, 1975] to. reflect repeal of

depletion."

H. Conf. Rept. 94-120 (1975), 1975-1 C.B. 624, 629.

In a nutshell, the legislative and administrative history of

percentage depletion consistently shows two related concerns on

the part of the legislators and administrators:

First, there was

concern about the possible abuse of the depletion deduction and

its use to reduce profits from other lines of business unrelated

to the purposes for depletion, those purposes being the return of

capital to encourage further investment in oil and gas and

recoupment for exhaustion of the resource.

Second, there was

15 Sec. 613A(b) provides:

(1) In General.--The allowance for depletion

under section 611 shall be computed in accordance with

section 613 with respect to--

*

*

*

*

*

*

*

(B) natural gas sold under a fixed

contract,

and 22 percent shall be deemed to be specified in subsection

(b) of section 613 for purposes of subsection (a) of that

section.

- 21 -

concern that integrated producers might be able to obtain a

competitive advantage over nonintegrated producers by taking a

depletion deduction on that portion of a finished product--

transportation, refining, or conversion--which already was

otherwise qualified for depreciation.

This concern about the

competitive position of nonintegrated producers is amply

described in the case law, e.g., Commissioner v. Engle, 464 U.S.

206, 208-218 (1984);" United States v. Cannelton Sewer Pipe Co.,

364 U.S. 76, 86-87 (1960); Hugoton Prod. Co. v. United States,

suora at 425-427, and is evidenced in section 613A(c), which

exempts independent producers and royalty owners from the repeal

of percentage depletion.

The fixed contract exception to the

repeal of percentage depletion in sections 613A(b)(1)(B) and

613A(b)(3)(A) assumed that sellers of natural gas under fixed

contracts could not obtain the benefits of higher prices and thus

were also entitled to continued use of percentage depletion at

the 22 percent rate.

Petitioners assert that one of the primary reasons for the

creation of percentage depletion was to simplify the system by

eliminating the need for a difficult and complicated valuation

process, and that this mandates the use of the RMFP's in all

In 1986, Congress prohibited depletion deductions on

advance royalties and bonuses, contrary to the holding in

Commissioner v. Engle, 464 U.S. 206 (1984). Tax Reform Act of

1986, Pub. L. 99-514, sec. 412(a)(1), 100 Stat. 2085, 2227; see

sec. 613A(d)(5). The Court's discussion of general historical

depletion policy remains sound, however.

- 22 -

cases.

The literal terms of the regulation, however, must be

viewed in context:

The RMFP technique referred to by the.Joint

Committee Staff and later embraced by respondent in the

regulation at issue was designed to prescribe a simplified method

by which to ascertain that portion of the taxpayer's receipts

which was attributable to the gas at the wellhead without

improvement or transportation; it thus was designed to separate

those portions of gross receipts which were.appropriate for

depletion from those which were not.

We see no indication that

it was designed to create income that never existed in order to

inflate a depletion deduction.

Compare Bloomington Limestone

Corp. v. United States, 445 F.2d 1105, 1110 (7th Cir. 1971) with

Gray Knox Marble Co. v. United States, 257 F. Supp. 632, 643

(E.D. Tenn. 1966).

To allow such an inflation also would be

.

completely contrary to the assumption behind the fixed contract

exception to the repeal of percentage depletion, for it would

give petitioners a "have your cake and eat it too" benefit that

would frustrate the purpose of section 613A.

Our review of the case law confirms this conclusion.

While

few of the cases deal directly with the last sentence of the

regulation at issue, a number of cases provide a great deal of

insight into what the concept "gross income from the property"

means in a more general context."

In Helvering v. Twin Bell Oil

Petitioners state that many of the cases discussed below,

which do not deal with sales away from the wellhead under the

last sentence of sec. 1.613-3(a), Income Tax Regs., but rather

(continued...)

- 23 Syndicate, 293 U.S. 312 (1934), an early case under percentage

depletion, the Supreme Court had to allocate percentage depletion

between a lessor and lessee of oil and gas income.

The taxpayer

wanted to use for gross income from the property the gross

production of the wells, including royalties paid, whereas the

Commissioner treated gross production less royalties as the

measure of the taxpayer's depletable interest."

Id. at 320.

The Court held for the Commissioner, in part because the

royalties were "gross income" to those receiving them, and to

embrace the taxpayer's position would have permitted a total

depletion allowance in excess of 100 percent of the taxpayer's

total receipts, which "would not be a single allowance,

apportioned between lessor and lessee."

Id.

The Court also

noted the requirement that one who takes a depletion deduction is

(...continued)

with the earlier portion of that regulation and situations where

the gas was sold in the vicinity of the well, are irrelevant to

the last sentence; this assumes that the last sentence of the

regulation is for some special reason not related to the general

"gross income from the property" concept. As discussed, our

review of the legislative history reveals that the last sentence

of the regulation was created in order to separate by a

relatively simple method that portion of total proceeds of a

transported item which was attributable to the gas at the well,

which is consistent with the scope and purpose of the rest of the

regulation and percentage depletion generally. Therefore,

petitioners' argument about the lack of relevance of these cases

is unpersuasive.

After the year at issue, Congress amended the percentage

depletion statute to authorize the procedure recommended by the

Commissioner and used by the Court in Helvering v. Twin Bell Oil

Syndicate, 293 U.S. 312, 322 (1934). Revenue Act of 1932, ch.

209, sec. 114(b)(3), 47 Stat. 202; see sec. 613(a).

- 24 -

required to have an economic interest in the property upon which

depletion is based.

By apportioning the royalty portion to the

recipient of the royalties, and the total receipts less the

royalties to the taxpayer, the Court indicated that it was giving

"regard to the economic interest of each of the parties entitled

to participate in the depletion allowance."

Id. at 321.

While

we note that respondent has stipulated for purposes of this

motion that "Exxon possessed the requisite economic interest in

the wells for which percentage depletion is claimed", this does

not mean that respondent concedes that Exxon possesses an

economic interest in the portion of the depletion taken in this

case in excess of the actual proceeds received.

We agree with

the Supreme Court in Twin Bell that it is hard to see how one

could have an economic interest in such a fictional amount.

The

predecessor to this Court cited Twin Bell with approval long ago

when it stated that "gross income from the property" meant "gross

income from the property received by the particular taxpayer

claiming a deduction for depletion and is synonymous with the

amount to be included in the taxpayer's gross income under

section 22."

McLean v. Commissioner, 41 B.T.A. 565, 575 (1940),

affd. 120 F.2d 942 (5th Cir. 1941).

In Crews v. Commissioner, 89 F.2d 412 (10th Cir. 1937),

certain funds in escrow had been misappropriated before the

taxpayers were entitled to them under the terms of a settlement

agreement.

Id. at 414.

The Court of Appeals for the Tenth

- 25 -

Circuit held that there was no gross income from the property as

to the misappropriated amount because the taxpayers had never

received this amount either actually or constructively, and that

gross income "to the taxpayer" is necessarily implied; clearly

the court there treated "gross income from the property" as being

within the.scope of gross income concepts generally.

Id. at 415.

The court stated:

To allow a deduction on the basis of income never

received and therefore no part of the gross income, on

the net part of which a tax is exacted would be

manifestly unfair. While oil extracted and sold to the

Refining Company depleted the land, the depletion

allowance is not granted to create a depletion reserve

but to allow a deduction from gross income for tax

purposes and there should not be included in such gross

income proceeds of oil never received by the taxpayer

and no part of which became subject to income taxation.

Id. at 416.

Similarly, the "phantom" income at issue here was

never received by petitioners, nor was it treated as income on

their consolidated return.

We find it at least as unfair to

allow it to be treated as gross income from the property as the

court did in Crews.

See also Commissioner v. Portland Cement Co.

of Utah, 450 U.S. 156, 172 (1981) ("gross income from mining

means income received, whether actually or constructively,

without regard to value"); Helvering v. Mountain Producers Corp.,

303 U.S. 376, 382 (1938) ("'gross income from the property' * * *

should be taken in its natural sense.

.With the motives which

lead the taxpayer to be satisfied with the proceeds he receives

we are not concerned.")

- 26 Although it dealt with the somewhat different legislative

history of depletion of minerals, the Supreme Court in another

case, United States v. Cannelton Sewer Pipe Co., 364 U.S. 76

(1960), made an important point that is highly relevant to the

instant case.

After reviewing the history of depletion generally

and minerals specifically, the Court emphasized that depletion is

an allowance for the exhaustion of capital assets, not a subsidy

for manufacturers.

Id. at 86.

The Court indicated that

"Congress intended to grant miners a depletion allowance based on

the constructive income from the raw mineral product, if

marketable in that form, and not on the value of the finished

articles."

Id.

Thus the location of the line between production

and manufacturing was important in that case.

In applying this

principle to this case, we are compelled to conclude that use of

the RMFP's in this situation would fly in the face of the

principles enunciated in Cannelton.

Use of the RMFP's here would

allow petitioners, integrated producers, to reap benefits not

intended for them, not only by allowing depletion on transported

gas, but at five times the actual proceeds therefrom, thereby

allowing completely unrelated profits to be offset.

This is far

beyond the "subsidy for manufacturers" that Cannelton prohibited.

In 1961, this Court decided the case of Shamrock Oil & Gas

Corp. v. Commissioner, 35 T.C. 979 (1961), affd. 346 F.2d 377

(5th Cir. 1965).

There we indicated that the last sentence of

the regulation providing for use of RMFP "shall be applied" to

- 27 sales of gas away from the wellhead, and did not discuss the

circumstances under which it was or was not appropriate to apply

an alternate method.

Id. at 1030.

We then went on to discuss

the method of determining the RMFP.

In connection with this

issue, we noted that for integrated producers under the

regulation "the amount of depletion may not vary with their

individual situations",'' but that "This is no reason for

departing from the general principle that the statute bases the

percentage on what the producer actually receives for the oil or

gas at the well rather than its market value."

Id. at 1038.

We

noted earlier cases such as Greensboro Gas Co. v. Commissioner,

30 B.T.A. 1362 (1934), affd. 79 F.2d 701 (3d Cir. 1935), where

the issue had been at what point to measure the gross income from

the property, and the Board had concluded that the price at which

the taxpayer sold its gas to the ultimate consumers clearly would

not be the figure to use, since transportation and distribution

costs did not constitute gross income from the.property for

depletion purposes.

Id. at 1368-1369.

We concluded in Shamrock

that we should rely upon the weighted average prices of gas

19

Petitioners quote from Shamrock Oil & Gas Corp. v.

Commissioner, 35 T.C. 979, 1038 (1961), affd. 346 F.2d 377 (5th

Cir. 1965), for this proposition that depletion in cases where

the gas is transported from the premises "may not vary with

* * * [producers'] individual situations." This quote was used

by petitioners out of context. It was made in the context of a

discussion of the method by which to compute the RMFP, not

whether the RMFP had to be used in all situations. Accordingly,

we do not find this sentence to be appropriately used as the

basis for an issue that was not discussed by the Court.

- 28 actually sold during the year at issue, regardless of when the

sales contracts were negotiated.

Shamrock Oil & Gas Corp.. v.

Commissioner, 35 T.C. at 1039-1040.

A series of cases in the United States Court of Claims

provides us with further guidance as to how the last sentence of

the regulation at issue is being interpreted in the courts.

In

Hugoton Prod. Co. v. United States, 161 Ct. Cl, 274, 315 F.2d 868

(1963) (Hugoton.I), the Court of Claims was urged by the

Government to use the "proportionate profits" method to calculate

gross income from the property, which is similar to the "net-

back" methodology employed by respondent in this case, and the

taxpayer wanted to use the "market comparison" (or RMFP) method.

The court required the use of the RMFP in that case, stating:

"The regulations provide that gross income from the property

shall be assumed the equivalent of the representative market or

field price at the wellhead so that, if there is such a price, it

must govern here."

Id. at 871.

Despite this broad language, the

Court of Claims, in discussing the rationale of the last sentence

of the regulation at issue calling for use of the RMFP, notably

stated:

From the outset, the producer has been held entitled to

include in gross income for purposes of the percentage

depletion allowance only so much of the proceeds from

the sale of the gas as he would have received had he

sold the gas at the wellhead. [Emphasis added; fn.

ref. omitted.]

Id. at 869.

The court went on to note that there were

considerable complexities involved.in the use of the RMFP, and

- 29 -

that perhaps the proportionate profits method might have been

more appropriate or feasible than the RMFP method, since the

former method "has the advantages of being related directly to

the taxpayer's own income".

Id. at 872.

Nevertheless, the court

concluded, the Government had chosen the RMFP method in the

regulation at issue, and the problem of determining an RMFP was

not "of such unusual or inordinate difficulty as to preclude use

of the method prescribed as the norm" by the regulation.

873.

Id. at

The court then went on to decide, following our holding in

Shamrock, that the RMFP should be based upon contracts under

which gas was sold during that year rather than contracts entered

- 30 into in that year.20

As we discuss infra, Hugoton I does not by

its own language require the use of an RMFP in all situations

where gas is sold away from the wellhead, and, to the extent that

petitioners conclude that it is intended to be read in that

manner, we do not agree with such a conclusion.

As the Court of

Claims observed in Hugoton I in its comments about the method of

determining RMFP, "the representative price is the price which is

in fact being obtained [emphasis added] under all existing

comparable contracts."

Id. at 874.

A "gross income from the

property" figure that is five times petitioners' actual gross

income for the gas after transportation can hardly be considered

20 The Court of Claims noted that the typical nonintegrated

producer had to enter into long-term contracts and obtained the

benefit of rising prices only to the extent that there were

escalator clauses in the contract; thus a method employing

contracts entered into over several years would tend to equalize

the depletion allowance as between integrated and nonintegrated

producers, as required by the Supreme Court in United States v.

Cannelton Sewer Pipe Co., 364 U.S. 76, 86 (1960). Hugoton Prod.

Co. v. United States, 161 Ct. Cl. 274, 315 F.2d 868, 876 (1963).

In noting that the integrated taxpayer in Hugoton might have

otherwise been able to benefit from price increases not available

to nonintegrated producers, use of the market comparison method

rather than proportionate profits method made the increases in

market price irrelevant because:

We look to see what price plaintiff would have obtained

for its gas at the wellhead if unintegrated, and we

must disregard any increases in gross income which he

obtains by virtue of the fact that he is integrated.

* * * .

[Emphasis added.]

Id. Thus the Court of Claims in choosing the weighted average

method of determining the RMFP was not willing to use the current

value of the gas, but required the use of the gross proceeds

received by the taxpayers under prices determined over a period

of years.

- 31 -

"representative".

The case in Hugoton I was remanded for further

findings on the appropriate RMFP.

Id. at 877.

During that remand, in United States v. Henderson Clay

Prod., 324 F.2d 7, 8 (5th Cir. 1963), the Court of Appeals for

the Fifth Circuit had to determine the taxpayer's "gross income

from mining", which is similar to the "gross income from the

property" calculation for oil and gas.

The mining regulation at

issue in that case differed from the regulation at issue here, in

that the mining regulation stated that, when the mined product is

processed or transported away from the mining cite, the taxpayer

used either the RMFP or, if there was no RMFP, a figure computed

by the proportionate profits method.

Id. at 9; see sec.

39.23(m)-1(e)(3), Regs. 118 (1953).

The taxpayer, an integrated

manufacturer that mined ball clay, transported and formed it into

bricks, fired the bricks in kilns, and shipped, stored, or sold

the bricks, used gross income from finished brick as the basis

for its depletion allowance on its tax return.

Henderson Clay Prod., supra at 9.

United States v.

After Cannelton held that the

percentage depletion allowance had to be cut off at the point

where the mineral first became suitable for industrial use or

consumption, the taxpayer had argued, and the District Court had

found, that there was an RMFP, a national market for shredded

ball clay, and that such a market was to be used.

Prod. v. United States, 199 F. Supp. 304, 311

Henderson Clay

(E.D. Tex. 1961).

In reversing and holding that the taxpayer had to use the

- 32 proportionate profits method, the Court of Appeals for the Fifth

Circuit found the following comparative figures to be

significant:

Actual Gross Income from

Sale of Brick

1951

1952

1953

1954

$468,694.11

465,668.33

482,294.78

520,684.56

324 F.2d at 12.

Hypothetical Gross Income from

the Property--Ball Clay

$562,172.10

543,436.95

563,842.65

581,570.85

After noting these figures, the court

responded. to the argument of the taxpayer that there was nothing

incongruous about allowing a "gross income from mining" that

exceeded the amount actually received by the taxpayer as follows:

Tax law is law unto itself. There are no

equities in tax law. And there is an area of

permissible illogic in tax law. But when a taxpayer

claims depletion on a fictitious gross income greatly

in excess of its actual gross income, we find the claim

highly indigestible.

Id.

Thus, the fact that the finished product (brick) actually

sold for considerably less than the hypothetical "gross income

from the property" based on the raw material (ball clay) was

simply an unacceptable result, one clearly contravening the

mandate in Cannelton that integrated manufacturers should not be

given a preference over nonintegrated mining companies.

The

court found that the price of ball clay was not representative

The court noted that the disparity between the price for

the brick and the representative (market) price for ball clay,

strange as it seemed, was explainable on the ground that there

was a relatively small market for clay as contrasted with brick.

United States v. Henderson Clay Prod., 324 F.2d 7, 10 (5th Cir.

1963).

- 33 -

because its use did not fulfill the statutory objective of

estimating that part of the integrated producer's gross income

which was attributable to the operation of mining.

Id. at 15.

Accordingly, the proportionate profits method had to be used

since that method came closer to effecting the legislative intent

of depletion.

Id. at 16.

Subsequent to the remand in Hugoton I, the parties'

positions were reversed from their earlier positions.22 in

Hugoton Prod. Co. v. United States, 349 F.2d 418 (Ct. Cl. 1965)

(Hugoton II).

In Hugoton II, the Court of Claims reaffirmed its

required use of the RMFP in that case and distinguished the

intervening decision of the Court of Appeals for the Fifth

Circuit in Henderson.

The Hugoton II court noted that rejection

of the RMFP had "necessarily followed" in the Henderson context

partly because, by using the RMFP or market comparison method,

the depletion allowance would not have been limited to the

taxpayer's income from the marketable product closest to the raw

mineral, since the figure computed by use of the market

comparison method "would give it credit for expenses it never

incurred."

Id. at 426.

This is similar to the result that would

22 The taxpayer contended that the RMFP could not be

determined on the basis of interstate sales because it was

engaged only in intrastate business, where prices were higher.

Hugoton Prod. Co. v. United States, 172 Ct. Cl. 444, 349 F.2d

418, 421 (1965) (Hugoton II). The taxpayer now argued for the

use of the proportionate profits method. Id. at 422.

- 34 follow here if the RMFP's were used.23

Because it found

Henderson's facts to be distinguishable, the Court of Claims did

not follow the Henderson result.24

The Hugoton II court held that "The 'representative market

or field price' required by the Regulation demands the

utilization of an accounting system which considers comparative

sales."

Id. at 427.

Subsequently, the Court of Claims dealt

with the question of comparative sales in Panhandle Eastern Pipe

Line Co. v. United States, 187 Ct. Cl. 129, 408 F.2d 690 (1969).

23 In Hugoton II the court also noted that in Henderson the

market comparison method did not reflect the taxpayer's

constructive income because there was no competition between the

taxpayer and miners of similar clay, which was not the case in

Hugoton II, where the taxpayer not only was in competition with

other producers but, because it was integrated, was able to

command a higher price than its competitors. The record on these

motions does not contain any evidence concerning the markets in

which petitioners competed, and we therefore are unable to engage

in a discussion of this matter. However, the Hugoton II court

found that use of the proportionate profits method there would

violate the spirit of Cannelton in that it would permit the

taxpayer to obtain a higher price and therefore result in an

advantage to the taxpayer because it was integrated. Id. at 426.

This is the reverse of the situation here, where use of the

RMFP's would provide an advantage to the integrated petitioners

not available to their unintegrated competitors, who would be

required to use the lower contract (actual) price under the fixed

contract.

24 In a subsequent case in this Court involving the

successor to the Hugoton Production Company, we acknowledged the

statements by the Court of Claims in the two prior Hugoton cases

that under the last sentence of the regulation the wellhead price

to be used is the RMFP. Mesa Petroleum Co. v. Commissioner, 58

T.C. 374, 380 (1972). We noted, however, that the alternative

method proposed (the so-called "Matzen" formula) could not be

used because the result "would improperly allow * * * [the

taxpayer] a depletion allowance on its gathering, manufacturing,

and marketing profits." Id. at 381.

- 35 In Panhandle, the court concluded that a comparative sale had

been proven to determine the market price at the wellhead.from

the Howell Field.

Id., 408 F.2d at 715-716.

Nevertheless, the

court rejected the use of the RMFP computed by this comparative

sale and required use of a proportionate profits method.

The

Court of Claims found that, despite the strong language used in

Hugoton II that a literal reading of the regulation at issue

"'forecloses any consideration of a proportionate profits

formula'", id. at 717 (quoting Hugoton Prod. Co. v. United

States, 349 F.2d at 427), the RMFP method prescribed in the

regulation had been characterized by the Hugoton I court as a

"norm", and in Panhandle the determination of an RMFP presented

sufficient difficulty that it was not precluded from using

another method from that norm, id.

The difficulty in determining the RMFP articulated by the

court was that, while a market price of 32-1/2 cents per MCF

had been proven for the sales of gas at issue, this also was the

same as the price that the taxpayer received for the gas after it

was gathered, transported, and delivered away from the wellhead.

Id. at 716.

The court concluded that

using the market comparison method and making such a

determination on the basis of the unusual facts

existing with respect to the issue at hand would

stretch to the breaking point the doctrine of the

Hugoton and Shamrock cases, supra, and conflict with

the basic objectives underlying the decisions therein;

defeat the purposes which led to judicial approval of

25 An MCF is 1,000 cubic feet and is a standard of measure

for natural gas.

- 36 -

the market comparison method including the use of

weighted-average prices; and produce a price that could

not be reasonably and realistically considered

representative of plaintiff's economic situation or a

"representative market or field price" in any real

sense of such term.

The above-mentioned consequences of establishing

32-1/2 cents per MCF of gas for all of plaintiff's

Howell Field production add up to an end result

essentially parallel in effect to the one that, among

other factors, led the court, on appeal, in United

States v. Henderson Clay Prod., 324 F.2d 7 (5th Cir.

1963), to reject the use of the market comparison

method because it found such method to be "highly

indigestible" [324 F.2d at 12]. We, too, find that a

determination by us here that a 32-1/2 cent price was

the representative market or field price for

plaintiff's production of gas sold at said price after

it was transported and delivered away from the least

property would produce an indigestible result which we

decline to swallow. [Fn. ref. omitted.]

Id.

Certainly an even more compelling case is presented here,

where the affidavits and exhibits attached to the instant motions

indicate that petitioners' proceeds for the gas at issue after it

was transported away from the wells were far exceeded by the

RMFP's used by petitioners on their return, a fact which

petitioners do not appear to dispute."

Moreover, the purpose

for the RMFP method was to provide a means by which parties could

ascertain what portion of the taxpayer's proceeds from the sale

of transported gas were attributable to the wellhead cost.

We note that petitioners, in opposing respondent's

motion, do not dispute the fact that the RMFP's used on their

return exceeded their proceeds, but contend that as a matter of

law the regulation mandates the use of RMFP in all situations

where gas is sold away from the wellhead, regardless of the

actual proceeds received.

- 37 =

Hugoton Prod. Co. v. United States, 161 Ct. Cl. 274, 315 F.2d

868, 869 (1963).

It clearly was not designed to create "income

from the property" that far exceeded the taxpayer's proceeds, for

this would allow a depletion allowance on income that may already

have been attributable to a depreciation deduction, a result not

indicated by the legislative history.

We note that the statute

at issue provides for a "reasonable allowance for depletion"

under the "peculiar conditions in each case".

Sec. 611(a).

Under the facts here, the use of the RMFP's would not be

reasonable.

The net-back method of determining gross income from

the property proposed by respondent, which is similar to the

method required by the Court of Claims in Panhandle, is far more

appropriately used here."

27

Petitioners also attempt to distinguish United States v.

Henderson Clay Prod., 324 F.2d 7 (5th Cir. 1963), on the ground

that it arose under the mining regulations, which specifically

provided for the use of the proportionate profits method where an

RMFP could not be determined, whereas the regulation at issue

does not. Sec. 1.613-4(d), Income Tax Regs. The mining

regulation subsequently also contained a presumption that, where

the RMFP plus nonmining processes exceed the actual sales price,

that price is not a representative price. Sec. 1.613-4(c)(6),

Income Tax Regs. Petitioners further state that respondent had

proposed to extend the hard minerals regulation to oil and gas

but later withdrew that proposal, purportedly indicating an

intent that it was not applicable. However, we agree with the

reasoning of the Court of Appeals for the Fifth Circuit in

Henderson where it applied the same principles to a clay mining

situation as it had to an oil and gas situation and stated that

"The problem of depletion for the integrated driller-processor or

driller-transporter raises the same definitional problems in the

determination of gross income." United States v. Henderson Clay

Prod., 324 F.2d at 14. We note, moreover, that in Panhandle

Eastern Pipe Line Co. v. United States, 187 Ct. Cl. 129, 408 F.2d

690 (1969), the Court of Claims applied the same holding in an

oil and gas situation as we do here, without the existence of an

(continued...)

- 38 We conclude that use of the RMFP's here, resulting in an

income from the property for 1979 far in excess of petitioners'

actual gross income after the gas was transported away from the

wellhead, would be unreasonable in light of the legislative

history of and purposes for depletion and the case law

interpreting the relevant statute and regulation.28

Accordingly,

petitioners may not use EWFP's in computing their 1979 percentage

depletion for the gas in question, and petitioners' cross-motion

for summary judgment will be denied.

On the other hand, it is

reasonable to permit the use of the type of net-back method used

by respondent herein to determine petitioners' gross income from

the property for the 1979 tax year.

Since the net-back method

starts with petitioners' actual sales proceeds and reduces them

by, inter alia, royalties and transportation expenses,

petitioners will not be permitted to compute percentage depletion

(...continued)

oil and gas regulation. In the absence of any indication as to

why respondent chose to withdraw the proposed regulations, we

refuse to speculate, and we reach a logical result, as the Court

of Claims did in Panhandle.

28 In reaching this conclusion, we do not hold that the

regulation is invalid; we hold only that the method provided by

the last sentence is not applicable to the facts of this case.

There may be particular situations in which it is reasonable

based upon the "peculiar facts" to allow use of the RMFP even

where it exceeds the taxpayer's actual gross income. We are not

prepared even to attempt to define such situations or to

delineate for other cases where the use of the RMFP may or may

not be unreasonable. We only hold that its use would be

unreasonable here where the result of using RMFP's is five times

the actual sales proceeds from the sale of gas after it was

transported away from the wellhead.

- 39 -

on the basis of gross income from the property that is greater

than the actual sales proceeds of the gas in question.

Respondent's motion will be granted.

An order granting

respondent's motion for partial

summary iudgment and denying

petitioners' cross-motion for

partial summary judgment will be

issued.